Understanding the financial system with ecological models

STORY BY Artem Kaznatcheev

Published: June 11, 2013

The brand new Centre for Networks and Collective Behaviour at the University of Bath offers a new lens through which to view the financial crisis. In the inaugural meeting on Uncertainty in Interaction Networks, you can learn how ecological models can help us better regular the financial system.

Physics and mathematics; ecology and epidemiology; and economics and finance; -- you'd expect experts in these fields to be at opposite corners of your university campus. But at Meton College, all six fields intersect at Professor Robert M. May, Lord May of Oxford. Trained as a theoretical physicst (PhD 1959, University of Sydney),, in 1971 he transitioned to ecology and helped transform the field from shunning equations to a vibrant community on observation, experiments, and mathematical models. Guided by foundational questions in the field, he explored the discrete logistic map to co-founded and popularize chaos theory. In 2008 he ipivoted yet again by harnessing his knowledge of ecology and epidemiology to study the financial ecosystem.

In ecology, early research on fisheries fixated on single species. The financial equivalent is a bank worrying only about only its own risk-management strategy. However, fishes are intertconnected in an ecological network and the external stresses fish species experiences are not independent, something like a change in local currents or graduale global increase in temperature effects all species at once. Analogously, banks are connected through an inter-bank loan network and the sudden devaluation of an external asset class -- like the housing market in 2008 -- affects many banks at once. As over-consumption depleted fisheries in spire of ecologists’ predictions, the researchers realized that they must switch to a holistic view; they switched their attention to the whole ecological network and examined how the structure of species’ interactions aids or hampers the survival of the ecosystem. The regulator's dilemma in financial systems must be viewed through the same lens by using network science to manage systemic risk.

In the case of a financial crisis, ideas from epidemiology can help to contain it. As one individual becomes sick, he has the risk of passing on that illness to his social contacts. In finance, if a bank fails then the loans it defaulted on can cause its lenders to fail and propagate through the loan network. Unlike engineered networks like electrical grids, an epidemiologist does not have control over how humans interact with each other -- she can’t design our social network. Instead, she has to deter the disease through selective immunization or by encouraging individual behavior that might or might not be adopted. Similarly, central banks cannot tell all other banks who to loan to, instead they must target specific banks for intervention (say through bail-out) or by implementing policies that individual banks might or might not follow (depending on how these align with their interests). The financial regulator can view bank failure as a contagion and adapt ideas from public health.

The nest part of network science is that these commonalities can be made precise by applied mathematics and computer science. May and colleagues do this by applying tools from theoretical ecology to build analytic models of financial systems.  Best of all, the cross-fertilization is not one-sided; in exchange for mathematical tools, finance provides ecology with a wealth of data. The Federal Reserve Bank of New York can look at the interaction of 9500 banks with a total of 700000 transfers to reveal the topology of inter-bank payment flows -- ecologists can only dream of such detailed data on which to test their theories.

To avoid interdisciplinitis in such a melding of fields, it is important to foster communication between scientists in all six (and many more) of the disciplines that make up network science. The University of Bath is doing this by launching the Centre for Networks and Collective Behaviour with an inaugural two day meeting about Uncertainty in Interaction Networks on June 12th and 13th. If you are near Bath, UK then I recommend attending. While you're there, you can learn much more about the connections between network sciences and finance by listening to  the two keynots by Robert May on "Complexity, Uncertainty, and Consequent Fragility in Financial Networks" and Sheri Markose on "Financial Networks, Contagion and Systemic Risk". I wish I could attend as well, but there's no overnight bus across the Atlantic.

 

This post is partially based on my earlier article: "Mathematical models in finance and ecology"; follow the link for a more thorough overview.

Other Stories by Artem Kaznatcheev
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